Econ 1101/1165—Reading 4
Carbon Taxes and Cap and Trade for Carbon
Emissions
By Thomas J. Holmes, Dept. of
Economics, University of Minnesota
Revised October 9, 2022 for Econ 1101
and Econ 1165
Section 1. Climate
Change and Policy
There
is broad scientific consensus that human action in the form of the burning of
fossil fuels is contributing to the warming of the planet. Burning fossil fuels releases carbon, which
is a “greenhouse case.”
Externalities
occur at various levels, from as narrow a level as within a household, to as
wide a level as across the globe. For a
policy to successfully address an externality, it needs to be implemented on as
wide a level as the externality occurs.
Consider four examples:
·
Within Household. An example of a negative externality that
might occur within a household is the case of a spouse not making the bed or
leaving the toilet seat up.
“Regulations” or “taxes” at the household level are usually sufficient
to work these things out!
·
Local Level. Septic systems used by cabins and rural homes
release wastewater that can affect local groundwater. These are mostly regulated at the local or
state level.
·
National Level. SO2 (sulphur
dioxide) is a pollutant that causes acid rain.
Electric power plants release SO2 into the air and winds can
blow it hundreds of miles away. Thus, a
power plant in Illinois can cause acid rain in New York. SO2 is regulated at the national level. It should be clear that state-level
regulations will not be sufficient, because the state of Illinois will likely
not fully take into account the interests of New York.
·
Global Level. Burning carbon is different from all the
above in that its reach is global. A power plant in Illinois burning fossil
fuels releases carbon gases that diffuse into the global carbon cycle.
As
carbon is an externality operating at the global level, addressing the issue
ultimately requires global cooperation.
The world forum that is attempting to work this issue out is the United Nations Framework Convention on Climate
Change. An important conference
was held in Paris in the fall of 2015, which resulted in the Paris Agreement. The “Climate Action” web page of
the United Nations contains a wealth of information about both the science of
carbon emissions and policy issues.
In
class, we discuss how taxes can be used to promote efficiency in markets with
negative externalities. Suppose
throughout the entire world we implement a carbon tax of $100 per ton of carbon
emitted. (I am throwing that number out
just for the purpose of discussion, but I will add that it is in the range of
tax levels proposed in a number of studies.) Suppose that the tax revenue went to the
United Nations who then used the tax revenue to buy food and health care for
poor countries (and help poor people negatively impacted by climate change,
e.g. Pacific Islanders being flooded). To
make this more concrete, a $100 per ton carbon tax is roughly equivalent to a $1
per gallon tax on gasoline. To get a
sense of the potential magnitude of tax revenue, note that in 2021 total global
emissions of carbon were 36 billion tons.
If emissions stayed the same under the tax (e.g., if emissions were
perfectly inelastic which it’s not), the tax would raise $3.6 trillion per year. Of course, the idea of imposing the tax would
be to incentivize a decrease in emissions.
We expect the tax revenue would be less.
But still a lot of money would be raised.
Back
to reality. A global tax on carbon collected
by the United Nations is not going to happen.
Instead, the current focus by the United Nations is on agreements where countries
each commit to reduce carbon emissions by a certain amount. Then it is up to the individual countries to
decide for themselves how they will meet their target reductions.
One
way a country might meet its target reduction is through a carbon tax (where
the country keeps the tax revenue for itself). Generally, coal-burning electricity
producers and other heavy carbon emitters lobby against carbon taxes. These lobbying interests may need to be
bought off with a cap-and-trade system.
Remember from Reading 3, the economics of a cap and trade is exactly
like a tax except for one difference: the “tax revenue” in a quota system goes
to the owners of the quota rather than the government. In cap and trade systems, the quota (called
allowances in the context of carbon) generally go to the existing carbon
emitters, as a kind of bribe to get them to go along with the policy. The European
Union has adopted a cap and trade system as one component of its strategy to
reduce carbon emissions. In the European
Union, the current market price of the right to emit one ton of carbon is approximately
€70. (And with the dollar and euro now
approximately at parity, this is about $70 a ton.)
In
the United States, when Barack Obama was elected president in 2008, there was a
lot of discussion that a cap and trade system for carbon emissions might be implemented
at the federal level here. Earlier, in
1990, a cap and trade system at the federal level was set up to limit sulphur dioxide. The
1990 legislation is widely considered to have been successful in helping to
reduce acid rain pollution in an efficient way.
(See “How
economics solved acid rain,” by the Environmental Defense Fund.) But an analogous program for carbon emissions
was never established at the federal level.
(There are some cap and trade programs for carbon at the state level,
including California’s program.)
This
past August, a major climate bill finally did pass in Washington. The climate legislation was included in the “Inflation
Reduction Act,” (IRA) which addressed a variety of policy issues besides
climate, including drug pricing. But
rather than impose a carbon tax (or an effectively create a carbon tax through
cap and trade), the new bill tries a different strategy which is to subsidize
clean energy. It is useful to note the
contrast between a carbon tax and a clean energy subsidy. A carbon tax lowers carbon emissions by
directly making carbon more costly to use. (It’s a “stick.”) A clean energy subsidy lowers carbon by making
the alternatives more attractive. (It’s a “carrot.”) Also, obviously, a tax raises money for the
government while a subsidy costs the government money. It is perhaps not surprising that subsidies
are more popular politically than taxes or cap and trade. An issue with clean energy subsidies is that
it puts the government in the job of picking winners and losers in terms of who
to subsidize. There are big debates
about how successful governments are at this job relative to letting the market
decide which technologies succeed.
Section 2. The Economics of Carbon Taxes and Allowances
in an Example
Let’s
examine the economics of externalities and allowances by working through the
same numerical example we have used in the previous case studies. Figure 1 illustrates the demand and supply
curves for carbon-based energy for the example.
In the free market, the equilibrium price of carbon-based energy is
price is $5 and the equilibrium quantity is 5 units.
If
a $4 per energy unit “carbon tax” is imposed in this market, the equilibrium
quantity of carbon-based energy is reduced to 3 units. If we ignore the externality and pay
attention only to the sum of producer surplus plus consumer surplus plus
government surplus, this sum decreases by the amount of the yellow triangle in
Figure 1. Table 1 shows the
corresponding numbers. This sum—the
change in total surplus excluding
the externality—decreases by $4. So far
this analysis should look very familiar.
It is the usual analysis of the impact of a tax when there are no
externalities to worry about.
Now
let’s take into account that the use of carbon-based energy has a negative
impact on the environment. Suppose for
the sake of this example that the cost to the environment is valued by society
at $4 per unit of carbon-based energy consumed.
On account of the externality, the socially efficient quantity of
carbon-based energy is no longer the 5 units obtained in the market
allocation. At the market allocation,
private marginal benefit from the demand curve equals private marginal cost
from the supply curve. For efficiency,
we need to take into account social
marginal cost. This includes the
private marginal cost of producing the energy (for example, drilling wells,
refining and transporting oil) plus
the $4 external cost on the environment.
This is illustrated by the SMC
curve in the right panel of Figure 1.
The socially efficient quantity is Q = 3 where social marginal cost
equals social marginal benefit. Here
social marginal benefit is given by the demand curve. (There are no positive externalities from carbon-based energy consumption, so
social marginal benefit equals private marginal benefit.)
By
looking at the right graph in Figure 1, we can see how the $4 carbon tax raises
total surplus by reducing output to the efficient level of Q = 3. Because output decreases by 2 units and
because the external cost per unit is $4, on account of the carbon tax, the
external cost decreases by $8 = $4×2. In
the figure, this gain to society is illustrated by the parallelogram outlined
in black. This gain is partially offset
by the loss in total surplus excluding the externality (the yellow triangle on
the right.) The net gain in total surplus is then the aqua-colored triangle on the
right-hand side figure.
Suppose
that instead of a carbon tax, a carbon allowance policy is adopted
instead. In particular, the government
distributes QAllowance = 3
allowances. Under this policy, in order
for a carbon-based energy producer to produce a unit of output, the producer is
required to have a unit allowance.
Suppose the allowances are tradeable in an exchange. This is exactly
like the dairy quota policy discussed in Reading 3; the only difference is the
use of the term “allowance” instead of the term “quota.” Just as in Reading 3, the equilibrium price
of an allowance will be $4. And just as
in Reading 3, the analysis of a $4 tax and a 3-unit allowance policy is the
same; the only difference is where the green box in Figure 1 goes. With a tax, the $12 green box goes to the
government as tax revenue. Under the
allowance policy, the green box goes to the individuals who are initially
allocated the allowances. In current
policies being discussed, allowances are being allocated to existing producers
of carbon based energy, such as electric power plants. This is being done for political
reasons. If the existing producers are
given the green box, they are less likely to use their considerable influence
to fight the policy change.
Figure 1: Impact of a
Carbon Tax with and without Taking into Account the Externality in Pictures
Table 1: The Impact of
a Carbon Tax in a Table
|
Variable |
Definition |
Free
Market |
Tax $4 |
Change
from Policy |
|
PD,Energy |
Energy price
consumers pay |
5 |
7 |
+2 |
|
PS,Energy |
Energy price
suppliers receive |
5 |
3 |
–2 |
|
QEnergy |
Quantity of
energy |
5 |
3 |
–2 |
|
Tax |
Tax on carbon-based
energy per unit |
0 |
4 |
4 |
|
CS |
Consumer
Surplus |
12.5 |
4.5 |
–8 |
|
PS |
Profit
energy producers make when the opportunity cost of using allowances is
subtracted out |
12.5 |
4.5 |
–8 |
|
GS |
Government
Surplus (Tax Revenue) |
0 |
12 |
12 |
|
Total Surplus Excluding External Cost |
CS+ PS |
25 |
21 |
– 4 |
|
Externality |
$4 per unit
external cost times number of units |
– 20 |
–12 |
+8 |
|
Total Surplus |
Sum of all
surplus including deduction from external cost |
5 |
9 |
+4 |